The Economy and the Bank of Canada Catch Their · The Economy and the Bank of Canada Catch Their Breath HIGHLIGHTS f The global economic context remains very favourable. f The Bank

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François Dupuis, Vice-President and Chief Economist Mathieu D’Anjou, Senior Economist • Jimmy Jean, Senior Economist • Hendrix Vachon, Senior Economist

Desjardins, Economic Studies: 514-281-2336 or 1 866-866-7000, ext. 5552336 • [email protected] • desjardins.com/economics

NOTE TO READERS: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively.IMPORTANT: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein are, unless otherwise indicated, those of the document’s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright © 2017, Desjardins Group. All rights reserved.

The Economy and the Bank of Canada Catch Their BreathHIGHLIGHTS

f The global economic context remains very favourable.

f The Bank of Canada takes a pause as Canadian growth eases.

f The Canadian dollar dropped back below US$0.80.

f Things are starting to come together for Canada’s equity market.

• The hurricanes didn’t significantly slow down the U.S. economy. Real GDP rose 3.0% (annualized) in the third quarter of 2017 in the United States, according to the advance estimate for national accounts. This exceeded expectations and was close to the 3.1% gain it achieved in the spring. This positive trend for the economy should prompt the Federal Reserve (Fed) to continue hiking its key interest rate in December. The news is just as promising for most of the other major economies as confidence indexes remain high (graph 1).

• The Canadian economy slows to more sustainable pace. After posting skyrocketing growth from mid-2016 to mid-2017,

the Canadian economy appears to have eased up with growth looking to be slightly below 2% in the third quarter (graph 2). This slowdown is primarily due to declines in exports and retail sales. However, this more moderate pace of growth is not cause for concern as the labour market’s solid performance and the high levels of consumer and business confidence remain favourable indicators for the Canadian economy.

• More gradual hikes for Canadian key interest rates are expected. After two consecutive rate increases in July and September, the Bank of Canada (BoC) maintained its target for the overnight rate at 1.00% in October. It has signalled that

ECONOMIC STUDIES | NOVEMBER 2ND, 2017

GRAPH 2 A well-deserved break for the Canadian economy

Sources: Statistics Canada and Desjardins, Economic Studies

Real GDP by industry

In 2007 $B

1,645

1,665

1,685

1,705

1,725

1,745

JAN. APR. JUL. OCT. JAN. APR. JUL. OCT. JAN. APR. JUL.

Quarterly averages

2015 2016 2017

GRAPH 1 The widespread surge in confidence continues

OECD: Organisation for Economic Co-operation and Development; * Brazil, Russia, India, China, Indonesia and South Africa. Sources: OCDE and Desjardins, Economic Studies

OECD members and six main emerging markets*

Index

98.5

99.0

99.5

100.0

100.5

101.0

101.5

102.0

2012 2013 2014 2015 2016 2017

Consumer confidence

Business confidence

#1 BEST OVERALLFORECASTER - CANADA

ECONOMIC STUDIES

2NOVEMBER 2017 | RETAIL RATE FORECASTS

other rate hikes are likely as the global and Canadian economic outlooks remain positive. However, it says it will be cautious in its next steps, as high household debt could amplify the restrictive impact of rate hikes on growth. Therefore, the next monetary policy tightening is not expected until early 2018.

• U.S. bond yields jumped back over Canadian yields. After having been buoyed by the sudden rise in key rates over the summer, Canadian bond yields recently succumbed to downward pressure when the BoC adopted a more cautious tone (graph 3). However, U.S. yield uptrend, which is expected to continue given the positive economic climate and the Fed’s clear intention to gradually normalize its monetary policy, limited their decline and should continue to exert upward pressure on Canadian yield in the coming quarters.

• Retail rates should continue to rise, but at a more gradual pace. The BoC’s resumption of a more cautious tone is good news for mortgage borrowers, who may have feared that this summer’s aggressive rate increases would continue. However, it would be a mistake to think that retail rate increases are over. As the economic outlook remains favourable and the Canadian economy’s excess capacity appears limited, we need to be prepared for gradual rate increases in 2018 and 2019.

DISCOUNT RATE

PRIME RATE

1 year 3 years 5 years 1 year 3 years 5 years

Realized (end of month)April 2017 0.75 2.70 3.14 3.39 4.74 0.85 1.15 1.50May 2017 0.75 2.70 3.14 3.39 4.74 0.85 1.15 1.50June 2017 0.75 2.70 3.14 3.39 4.74 0.85 1.15 1.50July 2017 1.00 2.95 3.14 3.39 4.74 0.85 1.15 1.50August 2017 1.00 2.95 3.24 3.39 4.84 0.90 1.15 1.55Sept. 2017 1.25 3.20 3.24 3.59 4.84 0.90 1.15 1.55Oct. 2017 1.25 3.20 3.39 3.74 4.99 0.90 1.15 1.55

ForecastsEnd of quarter2017: Q4 1.00–1.50 2.95–3.45 3.14–3.64 3.49–3.99 4.74–5.24 0.75–1.25 1.00–1.50 1.40–1.902018: Q1 1.25–1.75 3.20–3.70 3.24–3.74 3.49–3.99 5.00–5.50 0.90–1.40 1.25–1.75 1.70–2.202018: Q2 1.25–1.75 3.20–3.70 3.45–3.95 3.60–4.10 5.25–5.75 1.10–1.60 1.40–1.90 1.90–2.402018: Q3 1.50–2.00 3.45–3.95 3.55–4.05 3.90–4.40 5.60–6.10 1.25–1.75 1.70–2.20 2.20–2.70End of year2018 1.50–2.50 3.45–4.45 3.70–4.50 3.95–4.75 5.60–6.40 1.35–2.15 1.75–2.55 2.25–3.052019 2.00–3.00 3.95–4.95 4.05–4.85 4.30–5.10 5.80–6.60 1.70–2.50 2.00–2.80 2.45–3.252020 1.75–2.75 3.70–4.70 3.65–4.45 3.80–4.60 5.30–6.10 1.40–2.20 1.60–2.40 2.00–2.80

1 Non-redeemable (annual); NOTE: Forecasts are expressed as ranges.Source: Desjardins, Economic Studies

TABLE 1Forecasts: Retail rate

IN %

MORTGAGE RATE TERM SAVINGS1

GRAPH 3 U.S. rate hikes recently limited the drop in Canadian rates

Sources: Datastream and Desjardins, Economic Studies

In %

0.81.01.21.41.61.82.02.22.42.62.83.0

JAN. APR. JUL. OCT. JAN. APR. JUL. OCT.

United States Canada

2016 2017

10-year federal bond yields

3NOVEMBER 2017 | RETAIL RATE FORECASTS

ECONOMIC STUDIES

• The U.S. dollar was up compared to September (graph 4). It benefited from growing confidence in the strength of the U.S. economy and the continuation of its monetary tightening. At the same time, expectations regarding the monetary policies of several other countries were curbed.

• Following a second consecutive key rate increase by the Bank of Canada, the loonie neared US$0.83 in September. Thereafter, Canada’s more mixed economic data and the adoption of a more cautious tone by monetary authorities encouraged the markets to bank on fewer interest rate increases, and the Canadian dollar fell back below US$0.80 (graph 5). Recurring uncertainty over the survival of the North American Free Trade Agreement (NAFTA) also had a negative impact on the Canadian dollar.

• The pound performed better recently, while the Bank of England is expected to order one or two interest rate hikes to counter growing inflationary pressures in the United Kingdom. Across the Channel, the European Central Bank announced a reduction in its securities purchases for January. However, it didn’t give a clear indication of when it would end its purchases completely, causing the euro to fall to about US$1.16.

• Forecasts: The Canadian dollar’s potential for appreciation appears fairly limited in the short term. Nevertheless, it could approach US$0.80 (CAN$1.25/US$) between now and the end of the year if Canadian economic figures are good enough to prompt the BoC to announce another interest rate increase in January. For 2018, barring a shock, such as the United States’ withdrawal from NAFTA, the loonie should gain a few more cents due to the other interest rate hikes we forecast.

Exchange RateThe Canadian Dollar Dropped Back Below US$0.80

GRAPH 4 The greenback continues to rebound

Sources: Bloomberg and Desjardins, Economic Studies

DXY effective exchange rate

Index

90

92

94

96

98

100

102

104

2015 2016 2017 2018

Sources: Datastream and Desjardins, Economic Studies

US$/C$

-80

-60

-40

-20

0

20

40

0.680.700.720.740.760.780.800.820.840.86

2015 2016 2017

Canadian exchange rate (left)

Spreads between two-year rates with the United States(right)

Spreads in basis points

GRAPH 5 The Canadian dollar erases its recent gains

Q3 Q4 Q1 Q2 Q3 Q4f Q1f Q2f Q3f Q4f

US$/CAN$ 0.7617 0.7445 0.7511 0.7713 0.8020 0.7900 0.8000 0.8000 0.8100 0.8200CAN$/US$ 1.3129 1.3433 1.3313 1.2965 1.2470 1.2658 1.2500 1.2500 1.2346 1.2195CAN$/€ 1.4754 1.4168 1.4239 1.4787 1.4741 1.4810 1.4500 1.4625 1.4568 1.4634US$/€ 1.1238 1.0547 1.0696 1.1406 1.1822 1.1700 1.1600 1.1700 1.1800 1.2000US$/£ 1.2990 1.2357 1.2505 1.2990 1.3417 1.3300 1.3000 1.3000 1.3000 1.3000

f: forecastsSources: Datastream and Desjardins, Economic Studies

TABLE 2Forecasts: Currency

END OF PERIOD

2016 2017 2018

Determinants Short-term Long-term

Oil prices → ↗Metals prices → ↗Interest rate spreads → ↗

ECONOMIC STUDIES

4NOVEMBER 2017 | RETAIL RATE FORECASTS

• Investors who opted to reduce their exposure to stocks early in the year are stilling feeling the burn. Markets continued to climb, seemingly oblivious to geopolitics and initiatives taken by some central banks to cut back on monetary stimulus measures. Once again, emerging countries set themselves apart, with the MSCI Emerging Markets Index posting a change of close to 30% since the start of the year (graph 6). While the U.S. stock market has had another strong year, we can’t say the same for the Canadian stock mark, which remained one of the few stock markets to post a negative performance for much of this year. However, the situation has turned around since September. Meanwhile, the European markets posted slightly more modest growth than elsewhere, primarily due to their mediocre performance in the second half of the year. Tensions in Spain and the mess resulting from Brexit were among the factors hindering performance.

• Good news: The U.S. stock market is relying a bit less on multiple expansion. There is no question that valuations remain high; the S&P 500 forward price/earnings ratio is slightly above 18, whereas the long-term average is closer to 16. However, for about six months now, earnings have led the charge. On a year-over-year basis, profit growth has been in the double digits for each quarter of 2017 (graph 7). While the energy sector’s return to profitability has certainly helped, we also observed a strong trend in information technology, which saw its earnings surge, posting an annual change of 35%. The cyclical nature of these stocks give them an edge. And the recovery in business investment bodes well. In the third quarter, real spending on equipment continued to rise, this time by 8.6%.

• While the increased contribution of fundamentals is reassuring, it won’t necessarily prevent multiples from rising again. The U.S. stock market managed to post a good performance, despite deflated hopes regarding the Trump administration’s economic initiatives. Nevertheless, with Congress passing a budget resolution in October, a stumbling block for tax reform has been cleared. In early fall, Republicans in Congress introduced their reform proposals, which included a corporate tax cut from 35% to 20% and a five-year window in which companies could fully expense equipment investments within the year of purchase. These are clearly stimulating measures for businesses, but they come with a budget bill of US$2,000B over 10 years (including other measures), a cost that seems prohibitive to a significant faction of the Republican party itself. Clearly, tax reform is far from guaranteed, and it should come as no surprise if any sign

Asset Classes ReturnThings Are Starting to Come Together for Canada’s Equity Market

GRAPH 6 Most stock indexes continued to rack up gains, while the S&P/TSX emerged from its slump

* In local currencies. Sources: Datastream and Desjardins, Economic Studies

Stock index peformance* In %

-5

0

5

10

15

20

25

30

MSCI EmergingMarkets

MSCI AsiaPacific

S&P 500 Stoxx Europe600

S&P/TSX

January 1 to June 30Since July 1

GRAPH 8 The shortcomings of the Canadian stock market made it less expensive than the U.S. stock market

* Compared to their averages from 2008 to 2017. Sources: Datastream and Desjardins, Economic Studies

Difference in forward price/earnings ratios*

Ratio

-7-6-5-4-3-2-101234

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

S&P 500 S&P/TSX

GRAPH 7 The upturn in corporate earnings was beneficial to the U.S. stock market’s performance

* Based on the results of the first 272 companies to report their third quarter earnings. Sources: Standard & Poor’s and Desjardins, Economic Studies

S&P 500 company earnings

Annual variation in %

-20-15-10-505

10152025

2012 2013 2014 2015 2016 2017

Estimates*

5NOVEMBER 2017 | RETAIL RATE FORECASTS

ECONOMIC STUDIES

Bank of Canada (BoC) dampened expectations regarding the continuation of its normalization. The Canadian 10-year yield, which had reached 2.20% on September 27, recently slipped below 2%. Despite the recent hesitation shown by Governor Poloz, we still expect three more rate hikes to be announced in 2018. The BoC estimates that the economy reached full capacity in the third quarter, and both monetary and tax policies are in stimulus mode. This means that, sooner or later, the BoC will be forced off the sidelines. South of the border, the Federal Reserve is still on course for a third rate hike this year, in December. Regardless of who is selected as the new chair, we expect three more rate increases in 2018, as overall conditions remain conducive to a gradual normalization of monetary policy. This situation suggests a negative return for bonds in 2018.

of progress in this regard boosts stock markets between now and the end of the year.

• In Canada, the S&P/TSX finally managed to move up in September, and the outlook remains fairly constructive. Canada’s equity market slump was increasingly difficult to explain. Oil prices had bottomed in June and metal prices saw an upswing over the summer, without the S&P/TSX being able to benefit from these developments. However, the plateau in oil drilling reached in the United States in August convinced investors that the price of the West Texas Intermediate (WTI) belonged above US$50 per barrel, a level that was crossed in mid-September. Incidentally, the S&P/TSX energy sector posted an increase of 5.5% since its latest bottom on September 7. Meanwhile, a number of investors noticed the S&P/TSX’s relatively attractive valuation (graph 8). The brightening backdrop has led us to adjust our return target for the Canadian stock market to 7.0%. It should continue to catch up next year in a context of broad global growth and an upsurge in U.S. capital spending, a situation that is generally favourable to Canadian exporters. Of course, the North American Free Trade Agreement (NAFTA) negotiations are a risk and need to be monitored. The postponement of the agreement deadline to March 31, 2018 has provided a little breathing room, at least.

• Bonds are on track to post a slightly positive return for 2017. The bond index recently turned around, as the

CASH BONDSCANADIAN

STOCKSU.S. STOCKS

INTERNATIONAL STOCKS

EXCHANGE RATE

3-monthT-Bill Bond index1 S&P/TSX

index2

S&P 500 index (US$)2

MSCI EAFE index (US$)2

C$/US$(variation in %)3

2006 4.0 4.1 17.3 15.8 26.9 0.22007 4.1 3.7 9.8 5.5 11.6 -14.42008 2.4 6.4 -33.0 -37.0 -43.1 22.12009 0.3 5.4 35.1 26.5 32.5 -13.72010 0.6 6.7 17.6 15.1 8.2 -5.22011 0.9 9.7 -8.7 2.1 -11.7 2.32012 1.0 3.6 7.2 16.0 17.9 -2.72013 1.0 -1.2 13.0 32.4 23.3 7.12014 0.9 8.8 10.6 13.7 -4.5 9.42015 0.5 3.5 -8.3 1.4 -0.4 19.12016 0.5 1.7 21.1 12.0 1.5 -2.9

2017f target: 0.70 target: 1.0 target: 7.0 target: 17.0 target: 20.0 target: -5.8 (0.79 US$)range 0.65 to 0.75 -0.5 to 2.5 4.0 to 10.0 14.0 to 20.0 17.0 to 25.0 -8.1 to -2.0

2018f target: 1.40 target: -1.0 target: 9.0 target: 8.0 target: 7.0 target: -3.7 (0.82 US$)range 1.00 to 1.60 -3.0 to 2.0 4.0 to 14.0 3.0 to 13.0 -1.0 to 13.0 -7.1 to 3.9

TABLE 3Asset classes percentage return

END OF YEAR IN %(EXCEPT IF INDICATED)

1 FTSE TMX Canada Bond Universe; 2 Dividends included; 3 Negative = appreciation, positive = depreciation; f: forecastsSources: Datastream and Desjardins, Economic Studies